Indulge in monkey business to get the best returns from China

China celebrates its new year on Monday, inaugurating the ‘Year of the Red Fire Monkey’. Yet the firecrackers may lack some of their appeal to investors with the current economic slowdown.

Yet the stock market in China should not be regarded as a bellwether of its economy. “Anyone who believes the Shanghai Stock Exchange is a leading indicator of the Chinese economy is hugely naive,” says David Coombs of Rathbone Unit Trust Management. He says the exchange is influenced “by fickle retail investors whose numbers ballooned last year”.

The Shanghai exchange has always been volatile and 2015 was a great case in point – it soared almost 62 per cent in the first six months, then slumped nearly 32 per cent in the second half. Yet its Composite Index delivered a 9.4 per cent return overall, outperforming the FTSE 100, Dow Jones and many other Western markets.

The rate of growth is slowing from high single digits to mid single digits. “This was inevitable,” says Coombs who is not concerned by the slowdown but is keeping a keen eye on the currently strong services sector. If that slows, he predicts, there may be larger troubles ahead.

The IMF has forecast GDP growth this year of 6.3 per cent for China by comparison with 3.4 per cent for the global economy. It still makes China, the second biggest economy in the world, appealing.

The massive fall in world stock markets this year is only partly a reaction to China. The lack of a proper recovery in mature Western markets, the sharp cut in oil prices, not knowing when printed money will be cancelled and fears from terrorism have had a larger impact.

China is a poor communicator. At the World Economic Forum in Davos last month, Fang Xinghai, vice-chairman of its securities regulator and a key adviser to president Xi Jinping, accepted the criticism. Last August, China carried out a surprise currency devaluation, causing the largest one-day decline since 1994. It is still not known which matching currency and what value is planned for the renminbi.

The country is trying to move from export-driven growth with a heavy industrial past to one based on domestic consumption and services. In the recent IGM Forum poll of leading economists, no-one disagreed with the opinion that China’s growth model is “unsustainable”. Many investors expected faster growth, absorbing ever more commodities from copper to oil. Visiting many major cities recently, there appeared to be no reason why skyscraper blocks were still being built on an enormous scale when so many were totally empty. With a largely one child per family custom, there is no spare population to take up such slack.

Sheridan Adnams, investment research manager at The Share Centre, stresses the contrast between China as a planned economy – setting its own production goals, prices and allocation of resources – and most developed nations where the economy is driven by market forces. He still feels growth will be above rates for developed economies “for some years to come”.

Credit is growing at almost twice the country’s official growth rate and yet there is under-performance by state enterprises. Asset bubbles are likely as Chinese savers have restrictions on investing overseas, leaving equities and property as their only routes. Adnams is concerned over the risk of a further devaluation against the dollar.

“China continues to face headwinds in the short term with the pace of economic growth continuing to slow,” says Martin Payne, Leeds-based director of wealth manager Brewin Dolphin. For investors accepting volatility, “today could represent a buying opportunity”, says Payne.

He tips three funds: First State China Growth with 40-50 stocks and an “outstanding long-term track record well ahead of its benchmark”, Scottish Oriental Smaller Companies (55 per cent in China) and JP Morgan Chinese Investment Trust which has 60 per cent in financials and IT related stocks.

The Edinburgh Dragon Trust is tipped by Coombs. The fund invests in Asia Pacific – a region heavily reliant on Chinese trade – excluding Japan and Australia and is currently trading at an 11 per cent discount to asset value which makes an attractive entry point.

Among investment trusts, there have been several strong performers over 10 years, according to Morningstar research for the AIC:

Jonathan Baker at Charles Stanley brokers in Leeds is steering clear: “Over-supply, economy slowing, wage costs up, people out of work and the price of steel at an all-time low.” He is unconvinced about its growth target. Exceptional performance over the long term has been achieved by First State Greater China Growth, capturing most of the upside of a rising market, says Heather Ferguson, investment analyst at broker Hargreaves Lansdown.

China offers several share classes. The ‘A’ form, quoted in renminbi in Shanghai and Shenzhen, is largely for domestic investors but can be sourced through a foreign institutional programme.

The other two forms are traded in HK dollars: ‘B’ is domestically listed but available to international savers and has liquidity issues whilst ‘H’ is listed in Hong Kong and available offshore.

Specialists like Old Mutual only now invest in ‘H’ but used to hold ‘B’ class. Diamond Lee, manager of its China Equity fund, says: “Concerns around China and the impact on the region are probably overstated. Valuation levels are at extreme lows at six times historic earnings, especially for property.”

Darius McDermott of discount brokers Chelsea Financial Services predicts the Chinese economy will slow further this year but guards against selling any holdings there now. His favoured equity funds are Invesco Perpetual Hong Kong & China and First State Greater China Growth.

Dale Nicholls, portfolio manager of Fidelity China Special Situations, which is up 75.3 per cent in three years, is finding some large cap businesses at reasonable prices among ‘A’ class shares. However, he is concerned about corporate balance sheets where debt has grown substantially and notably about banks where the full extent of their non-performing loans has not been recognised.